Agiomirgianakis, G. M., Asteriou, D. & Papathoma, K. (2003). The determinants of foreign direct

investment: a panel data study for the OECD countries (Report No. 03/06). London, UK:

Department of Economics, City University London.

City Research Online

Original citation: Agiomirgianakis, G. M., Asteriou, D. & Papathoma, K. (2003). The determinants

of foreign direct investment: a panel data study for the OECD countries (Report No. 03/06).

London, UK: Department of Economics, City University London.

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Department of Economics

School of Social Sciences

THE DETERMINANTS OF FOREIGN DIRECT INVESTMENT:

A PANEL DATA STUDY FOR THE OECD COUNTRIES

By George Agiomirgianakis, Dimitrios Asteriou and K. Papathoma

Department of Economics

Discussion Paper Series

No. 03/06

THE DETERMINANTS OF FOREIGN DIRECT INVESTMENT:

A PANEL DATA STUDY FOR THE OECD COUNTRIES

G. M. Agiomirgianakis1 D. Asteriou K. Papathoma

Hellenic Open University; City University City University

City University London

Abstract

This study examines panel data evidence concerning empirical relevance between

Foreign Direct Investment (FDI) attraction and its determinative effects. The main bulk of

FDI is among the developed countries. Indeed, OECD countries has probably been the most

potential group in undertaking FDI by caring out about 95% of the total outward FDI while,

on average, 75% of the world FDI was directed into OECD countries. In this paper, we first

present and analyse the theoretical/empirical findings on FDI, then we focus on assessing the

relative significance of the factors that may attract FDI via a panel data regression analysis for

a sample consisting of 20 OECD countries for 23 years (1975-1997). Our findings suggest

that certain variables such as human capital and trade regime, as well as, the density of

infrastructure appear to be robust under different specifications. Positive significance of the

agglomeration factor is also observed, confirming the relevant theoretical propositions.

However certain deferential variables, such as the governmental policy effect, could not be

fully captured due to the statistical homogeneity of the sample.

J.E.L. Classification: C23, F23

Keywords: Foreign Direct Investment, Panel Data Analysis

1 Address of Correspondence: Dr. G. M. Agiomirgianakis, Business School, Hellenic Open University, Sahtouri

16 and Agiou Andreou, Patra, Greece, E-mail: gmagiios@eap.gr

1

1. Introduction

Cross-border investment is considered to be one of the most striking features of the

global economy. The determinants, the growth enhancing effects, the motivations towards

the formation of FDI (Foreign Direct Investment), as well as, the undertaking and attraction

policies, have been topics of intensive research in the last two decades. Foreign direct

investment is broadly defined as capital flows resulting from the behavior of multinational

companies (MNCs). Thus, factors that may affect the behavior of MNCs could also affect the

magnitude and the direction of FDI. MNCs expand their activities abroad for a variety of

reasons including, among others, the exploitation of economies of scale/scope; the use of

specific advantages (Hymer, 1976); often due to a life-cycle pattern of their products or

simply because their competitors are engaged in similar activities. On the other hand,

governments are also engaged in a policy competition by altering key factors of their

economic policies, such as domestic labour market conditions; corporate taxes; tariff barriers;

subsides; privatization and regulatory regime polices, in order to enhance FDI activity in their

countries.

Although the interest on the FDI effects was originated in the mid-fifties, when the

first growth models appeared (Solow, 1956), the extent of multinational activities has

significantly augmented over the past two decades, implying FDI as a desirable element for

economic development, mostly because it is characterized by a combination of capital,

technology, marketing2, entrepreneurship and human resources management. Romer, (1993)

also underlines the influential role of FDI in transferring such factors across countries and

economic regions, and more specifically, he considers FDI as one of the contributory factors

in the diffusion, dissemination of knowledge and assimilation of technologies and ideas. FDI

often takes the form of capital flows from a parent company to its foreign affiliate, an activity

that is considered to be (i) transferring technical factors from a region to another; (ii)

substituting capital movement with labor mobility in host regions and (iii) capitalizing

domestic markets and thus reducing or eliminating their imperfections. FDI can be either

inward when foreigners purchase assets into the home economy or outward when home

citizens purchase assets abroad. Among many analysts who tried to analyse the causality

effects of FDI, Ethier (1986) suggests that uncertainty together with information may act as a

stimulus for FDI.

2 Balasubramanyan et al.(1996)

2

Barrell and Pain (1997), tried to examine diachronically, the relative rise in the world

trade share accounted by multinational enterprises (MNEs), and found that the aggregate

stock of FDI as a percentage of the total estimated output in the OECD countries increased

dramatically from 4.75% in 1975 to 10% in 1995.

In recent years, many nations lunched an open door policy towards FDI, in order to

capture the growth enhancing effects of FDI on investment, employment, productivity and

economic development in general. The approaches towards the formation of FDI activity

differ between the US and the European countries and they are subsequently different even

within the borders of the EU3. The European integration process and especially the Single

Market Programme (SMP) has affected positively the intra-EU FDI, either directly with the

removal of capital controls, or indirectly by increasing the level and growth of the overall

economic activity. It is estimated that the European Internal Market has increased intra EU

FDI stocks for the UK and Germany 8%-14% or around 0,5% of EU GDP at constant 1990

prices (EAG, 1996 and Barrel et al., 1997). The USA and Japanese inflows into the EU have

also been higher, mostly with the form of opening subsidiaries in EU countries, in their

attempt to overcome the external barriers of the European integration Progress. OECD

countries has probably been the most potential group in undertaking FDI between 1980 and

1995, by caring out, on average, about 95% of the total outward FDI, while EU-15 had a

share of about 44% in this period (Barrell and Pain, 1997). On the other hand, about 75% on

average, of the world FDI was directed into OECD countries and about 15% in EU-15.

Clearly, not only there is a rapid increase in FDI worldwide but also the main bulk of FDI is

among the developed countries (Barrell et al., 1997).

Given this major extend of FDI activity across OECD countries; we focus our paper

into assessing the relative significance of the factors that may attract FDI into OECD

countries. Indeed, this paper aims to explore the empirical evidence for FDI attraction and its

determinative effects, by assessing and quantifying empirically these determinants for a data

set that covers 20 OECD countries and runs from 1975 to 1997. Section 2, analyses the

relevant theoretical background in order to sustain our study. Section 3, briefly reviews the

literature on the determinants of FDI. Section 4, describes the data, as well as, the model

specifications and outlines the empirical methodology. The analysis utilizes a panel-data

study method in order to provide an extended specification of our empirical model and to

3 Indeed, there are major differences in the Institutional Framework for foreign investment promotion, in

nominal and real macroeconomic measures, as well as, in the population distribution and in labour and capital

mobility (see e.g. Pain & Young, 1996 and Raines et al. 1999).

3

evaluate more effectively the total average effect of determinative variables on FDI

concentration. In Section 5, we discus our results. Finally, Section 6 concludes our paper.

2.Theoretical Background

The related literature can be broadly divided in two branches: the first one examines

the impact of FDI in economic growth; while the second branch focuses on the determinants

of FDI.

Let us, first, start with the growth effects of FDI. According to this branch of research,

it is important to investigate the precise nature of the relationship between FDI and economic

growth; the preconditions for FDI to promote growth and the identification of the mechanisms

through which growth can be achieved. One of the first approaches is the Neoclassical

Growth Theory. Solow (1956) attempted to express a growth model into a simple production

function and to explore key variables that could provide steady growth rates. In his models,

he captures variables determining FDI in growth rates. On the other hand, within the

Endogenous Growth Theory, FDI flows may contribute either directly or indirectly into the

economic growth of an economy. Wang (1990) discerns the effects of FDI activity into direct

positive home-country effects, by stepping up production and transferring knowledge to local

suppliers and indirect effects by upgrading the quality of their workforce. FDI is considered

to be the major source of economic growth for the less developed countries

(Balasubramanyam et al., 1996) while relative similarities are also observed in EU. Indeed,

FDI inflows have contributed to the EU economic growth since foreign affiliates exhibit

relative greater propensity to undertake R&D expenditures and the relative higher

productivity while undertaking investment in EU than in their domestic market (Barrel et al.,

1997). Moreover, Barrel et al. (1997), using a model of labour-augmenting technical progress,

estimates for the period 1972-1995, that around 30% of the growth of the British FDI

manufacturing productivity is attributed to the FDI inflows. Blomstrom and Kokko (1996)

argue that there are evidence suggesting the enhancing effects of FDI on host countrys

employment and output rates and a significant potential spillover-effect towards local firms in

host regions. Girma and Wakelin (2002) examining whether productivity spillovers from FDI

activity occur in the UK economy, found that positive spillovers from MNCs occur to

domestic firms in the same sector and region as the foreign affiliates. Moreover, their findings

suggest that domestic firms may gain more from these spillovers if the technology gap they

have from foreign firms is low. Other studies have also found that FDI affects recipient

country's economic growth through new inputs (Feenstra & Markusen, 1994), through new

4

technologies and the subsequent spillovers to domestic firms (Krugman, 1979) and through

knowledge transfers (de Mello and Sinclair, 1995). The advent of endogenous growth theory

(Romer, 1990, Barro & Sala-i-Martin, 1995) has enabled research into channels through

which FDI can be expected to promote growth in the long run.

The second branch of literature on FDI, attempts to illustrate the basic set of

determinants controlling the motivations for cross-border investment. Early evidence

expressed by Mundell (1957) attempt to explain FDI in terms of relative factor endowments

and relative factor costs. Mundell (1957) concludes that in the presence of barriers to trade

and migration, as well as, with the existence of large differences between capital-rich and

capital-poor countries, the incentive for capital flows is greater. The geographical distribution

of new investments, however, suggests that FDI does not target only low GDP-level and low-

wage countries. According to IMF, the intra-EU FDI flows account for 4.5% of EU GDP in

1995, evidence suggesting that more additional explanatory variables affecting FDI should be

incorporated in a general equilibrium model. Within this framework many researchers

incorporated additional variables that are assumed to affect cross-boarder investment

decisions, such as, the market size; domestic labour market conditions; cultural and language

differences, exchange rate stability; as well as, governmental and geographical indicators.

Recent empirical studies stress the role of corporate restructuring and macroeconomic

evaluation of FDI cash-flows and analyze factors such as, financial incentives, and political

instability. Ex- Posterior theories consider more complicated aspects of the matter and have

pointed out the importance of product differentiation; the existence of imperfect competition

or trade costs and economies of scale in investment choice; the capacity of the domestic

market share from indigenous firms, educational variables and the role of human capital

accumulation (Krugman, (1991), Krugman and Venables (1995), Benhabib and Speigel

(1994)). Cheng & Kwan (2000) argue that none of the educational variables expressed as

percentage of population with primary high education, has positive significant effect on FDI.

Other studies attempt to analyze the role of governmental policies, trade regimes and financial

market capacity in taking FDI decisions. Also, empirical studies suggest several measures that

a government should take in order to attract FDI including tariffs (Barnes and Davidson,

1994), taxes, subsidiaries (Rains and Brown, 1999), regulatory regime and revitalization

policy (Curwen, 1997). Others, suggest that unit labour cost may be a significant factor (see

e.g. Barrell and Pain, 1999a) suggesting that 1% increase in the relative unit labor cost in

USA could result in 0.89% increase in FDI inflow in EU.

5

3. The Determinants of FDI

The purpose of this section is to provide a brief survey of the possible locational

variables, identified, here, as potential factors in influencing foreign investment decision,

assuming a priori homogenous economic consideration. The most intrinsic characteristics in

order to define FDI is to analyze its determinants, such as the market size; market growth;

economic development; agglomeration; urbanization; human capital; labor costs;

governmental and integration policies etc. Each of the above factors determines the

applicability of investing abroad.

At this point we find it necessary to mention that the well-documented relationship

between FDI and growth is an interactive process. Not only FDI promotes output levels in the

host economy but also the level of economic development, as a determinant, plays a

significant role in attracting FDI. Theoretical and empirical evidence consider two

mechanisms playing an important role in attracting FDI: (a) the market size and (b) the level

of economic development.

The former permits economies of scale exploitation and standard production factor

specialization, resulting in cost minimisation and market growth, consequently, improving the

total supply side (services and inputs) in the host economy. Bhasin et al (1994) followed by

Morrissey and Rai (1995), claims that the size of the domestic market, as well as, growth

prospects of recipient economy are highly taken into consideration when foreign investors

relocate production in the host country. The later argue that international agreements on trade

and investment also affect the volume and direction of FDI flows. Jeon (1992) and Wang &

Swain (1995) use profitability rates as a sensor for growth level and consequently, as an

explanatory variable for FDI, concluding that there exist statistical segnificance and positive

linkage between the two measures. Agarwal (1980) points out that FDI is considered to be a

function of output or sales of foreign firms in the host country. This is usually approximated

by the size of market either the absolute, captured by the level of GDP (Bandera and White,

1968), or the relative, expressed by the growth rate of GDP4- of the host country. In the

meanwhile other researchers used both measures to show that level of development and

market capacity play a decisive role in attracting and positioning FDI (Wang and Swain,

1995.

The second mechanism in attracting FDI inflows concerns the stage of economic

development and the so-called Investment Development Path (IDP) of the recipient country

(Barrell & Pain, 1998). A well-developed existing market infrastructure is expected to support

6

FDI decisions (De Menil, 1999). Major studies encounter and measure IDP rates using GDP

per capita proxies. For instance Agarwal (1990) and Mainardi (1992) emphasise the level

importance and growth prospectus of the real per capita GNP per se and the role of real GDP

growth in taking investment decisions in a region. Head & Ries (1996), Cheng & Kwan

(1999), use infrastructure factors, proxied by road constructions (km/km2 of land mass), and

additionally the regional income as potential variables for FDI attraction.

Another important supply condition, that is considered to be promoting labour-

intensive and export-oriented FDI, is the human capital both in terms of quality and

availability. In this the capital stock created by investing over and above the depreciated

capital, expands the productivity potentials of a firm or a country and enables FDI growth

enhancing effects (De Mello, 1997). This, however, presupposes a minimum human-capital

efficiency level and assumes that further training is attainable. However, empirical literature

concerning the impact of educational level on inbound FDI appears to be counter-intuitive.

Cheng & Kwan (2000), for example, argue that none of the education variables (expressed as

percentage of population with primarily and high education) has a positive and significant

effect on FDI, while Cheng & Zhao (1995) report similar results. Guntlach, (1995) argues that

the poor explanatory power of human capital accumulation is attributed to the fact that

education creates externalities and spillover effects in production, which are hard to capture

using standard set of variables. More explanatory power can be achieved by identifying the

role of human capital augmentation, rather than human capital accumulation, which may be

poor explanatory variable in growth models because the crucial role of educational variables

is difficult to be captured in using standard growth accounting.

Recent literature puts forward agglomeration effects as a significant factor of

attracting FDI. Venables, (1996a) argues that agglomeration economies arise from the

presence of other firms, other industries, as well as from the availability of skilled labour

force. Empirical evidence evaluating agglomeration effects is limited though, partly because

of data limitations and difficulties in obtaining definite statistical specifications. Wheeler &

Mody (1992) found that the US FDI is attracted by the size of the total inward investment.

Head et al (1995) using plant-level data argue that the locational FDI attraction in a sector is

mostly determined by the location of existing firms in that industry. Barrell and Pain (1999a)

point out that the FDI in Europe is attracted by agglomerations proxied by market size and a

5-year moving average of stock manufacturing patterns, among other determinants such as

4 Goldberg (1972) and Petrochilos (1989).

7

relative costs, technology and integration. Finally, Braunerhjelm and Svensson (1998) show

that FDI is highly sensitive in agglomeration patterns.

Governmental policies could also be important determinants of FDI flows since

governments consider FDI flows as means to fight unemployment and to enhance national

growth rates. Governmental policies can take a variety of forms such as tariffs, taxes,

subsidies, regulatory regime and privatisation policy. For instance a relative increase in

tariffs or taxes rates in the host country is expected to raise the cost of investment, resulting in

eliminated profitability rates. Cheng & Kwan (2000) having examined empirical evidence on

governmental capabilities and recourses found that governments are major catalysts for

economic restructuring and location attraction of inward FDI. Indeed, when the Chinese

government launched an open door policy, China has emerged as the second largest recipient

in the world (after US) since 1993. Morrisey and Rai (1995) point out the institutional

features of the recipient economy and the degree of political intervention as a catalyst for

economic restructuring and hence as a potential determinant of FDI.

Another possible determinant in attracting FDI inflows is the liberal degree of trade

regime. Although there exist obvious difficulties in measuring the above factor, a general

positive relationship between a liberal trade regime and FDI, is anticipated. In EU, UKs

success in attracting FDI inflows, was founded in three key factors: a) the liberalization of

foreign owner regulation, b) the privatisation programme in traditionally state activities

(telecommunication, railways, electricity, water), c) the financial deregulation, the Big

Bang in 1986, (Raines et al., 1999). Bhagwati, (1978) argues that FDI is captivated by

countries that implement export promotion than those promoting import substitution policy.

Milner and Pentecost (1996) proxy the trade regime as the ratio of exports to sales and sales

concentration ratio and report that both variables are found to contribute positively to FDI.

Wang & Swain (1995) examine the case of export-oriented FDI and find positive influence on

inbound FDI. Recently, the inherent disadvantage of closed economies is outweighed by the

launch of special Export Processing Zones. Cheng & Kwan (2000), for example, found that

the Chinese Economic Zones exert a positive and significant influence on attracting FDI.

New political factors have been clearly emerged due to global economic trends such

as economic integration among conjuncted nations and trade liberalization all around the

world. Recent studies5 report evidence that the Single Market Programme (SMP) among the

EU countries promoted the level of investment rates within member states. De Menil (1998)

5 Arrowsmith et al. (1997) and Pain (1997)

8

states that the EU involves increases in the flow of information and capital, which in turn

increase FDI flows.

Pain & Lansbury (1997) report ambiguous results concerning the labour market

reforms in UK, which although having reduced the total labour costs, they did not succeed on

promoting the anticipated FDI attraction. More specifically UK performed poorly in attracting

FDI from those sectors where innovations were growing most rapidly. Cheng & Kwan (2000)

report that wage costs have negative effects on FDI, contrary to Chen (1996), who found that

labour compensations do not have any influence on FDI and to Head and Ries (1996), who

outcome a completely neutral impact of wages.

4. Data and Methodology

In this section we will try to empirically assess the determinants of FDI for the OECD

countries. The panel data set used for this analysis covers 20 OECD countries6 and runs from

1975-1997. The database has been built using a number of different sources. The main source

was the World Bank CD-Rom: World Development Indicators (1999), while data from the

IFS-IMF (various issues) were used for the construction of the FDI over GDP ratio and data

from other national sources (in companion with the World Bank CD-Rom) were used for the

construction of the physical infrastructure proxies. All values used in the analysis are

expressed in US dollars in real terms. The scope of the model, although being formulated at a

relatively aggregated level, is to consider the diverse range of influences on decision making

in investing abroad.

Since both cross-section and time-series data are available, we estimate equations,

which take the following form:

yit = i + xit + it (1) where the pair of terms (i, t) expresses the transversal and temporal aspects of the per country

panel data, y and x are respectively the dependent variable and the matrix of explanatory

variables, and i is a parameter specific to each country7. The latter parameter (which varies only across countries and not over time) is introduced to take account of unmeasured features

specific to the countries concerned. The set of independent variables is measured prior to the

investment decision. This approach allows overcoming the problem of endogeneity when

examining macroeconomic flows (Baltagi, 1995).

6 Austria, Denmark, Finland, France, Greece, Ireland, Italy, Netherlands, Norway, Portugal, Spain, Sweden,

Switzerland, Great Britain, Australia, Japan, South Korea, New Zealand, Canada, Unites States 7 In fact, we estimate (1) under different assumptions about the structure of our panel data model. The constant is

specific to each country only under the fixed and random effects methods.

9

In the light of the previous analysis in Section 2 above, and in order to assess the

influence of the variables described, a foreign investment equation may be built up in the

following linear form:

(FDI/Y)i,t = i + 1 GY i,t-1 + 2 yi,t-1 + 3 (FDI/Y)i,t-1 + 4 Gexp i,t-1 + 5 h i,t-1 + 6 Open i,t-1 + 7 Road i,t-1 + 8 Rail i,t-1 + it (2) where (FDI/Y)i,t denotes the share of FDI to GDP for each country; so obviously Y is real

GDP, GY denotes real GDP growth and y is GDP per capita (both introduced as indicators

showing the level of development, the size of the market, and the growth potential of each

country), lagged share of FDI is introduced to take into consideration the existence of

agglomeration effects. Moreover, the implications of this variable are not only confined to

agglomerations but also signal the absorbing capability of a host country. We expect a

positive influence of this variable. The role of policy measures is captured by Gexp, which

denotes government expenditures.8 The Openness of the economy (trade regime) is captured

by the variable named Open, which is defined as the ratio of trade flows (exports plus

imports) over GDP (macroeconomic variables that are expected to have effect on the location

of FDI). Next, we consider the set of skills possessed by the workers in the economy, i.e. we

include human capital proxies in our equations. Hence, h denotes the level of human capital

measured as the ratio of pupils enrolled on secondary education over the total active

population (aged between 15-65). Finally, road (percentage of roads paved) and rail (railway

network proxy) are variables measuring the physical infrastructure of each country. To our

knowledge these variables have not been used before when studying the determinants of FDI

using longitudinal data. The scope of these variables is to assess the role played by the quality

and the concentration of infrastructure. These variables can also signal the level of

development and the population distribution of the host country. In principle, an extensive

network promotes trade within the country and helps a foreign investor to gain access to

separate or different markets at the lowest cost.

8 Unfortunately due to data unavailability, we cannot include more variables measuring the effects of

government policies such as financial incentives or wage effects.

10

5. Empirical Results

We consider equation (2) by using three different methods (namely common constant,

fixed and random effects), in order to test our data sample under different specific-country

characteristics estimations. The panel consists of 20 countries, and runs for a time span of 22

years (we miss one observation due to the lags introduced in the equation). The total number

of observations is 440, which is sufficient to produce robust estimates. Note also that T and N

are sufficiently large and of the same magnitude. The estimated results are summarised in

Table 2.

Column 2 presents the results under the assumption that there are no differences

between the economies, which is not implausible since our sample consists of a homogeneous

group of countries. An important finding is the positive and significant effect of human

capital. This is consistent with the findings reported by Cheng & Wang (2000) and Cheng &

Zhao (1995) who adopted the same approach for human capital. Despite the inconclusiveness

of previous empirical studies concerning the role played by human capital as described above,

and summarized in Table 1, our results suggest that an economy with high fraction of skilled

workers is likely to be much more productive and more desirable on behalf of foreign

investors.

The catalytic role played by the growth prospects of the recipient economy clearly

emerges lending support to the theory and empirical evidence outlined above (see for

example Agarwal, 1980 and Mainardi, 1992). Indeed our estimates reveal that investors are

influenced by the degree of development and the market size, in terms of GDP per capita and

GDP growth. Looking at the Table 2, both coefficients are found to be positively related to

the inbound FDI flows and statistically significant at conventional levels. Foreign investors

will invest in a country where the perceived profitability of their projects is secured and the

signals transmitted by the GDP are good indicators for doing so.

The potential role played by the agglomeration effects turn out be positive and highly

significant showing that past experience is very important for the increase of the share of FDI

among countries. This implies that the impact of the previous stock of investment creates

positive externalities, which is indicative of the present condition and the future prospects of

the host country. The US FDI, for example, is attracted by the size of the total inward

investment (Wheeler and Mody, 1992) or the location of the firms is influenced by the

location of other firms, which invested previously (Head et al, 1995). Our results are also in

line with Barrell and Pain (1997,1999b) who using panel data but different proxies (the

11

fraction of national GDP and the ratio of host country R&D stock) report that agglomerations

exhibit positive and significant impact on attracting more investment.

A liberal trade regime is positively and significantly associated with the FDI inflows,

suggesting that, all things being equal, investors are more likely to invest in the countries

which have been opened up to the outside world (Milner and Pentecost 1996). The role of

trade is frequently taken into consideration, but it commonly agreed that there are other

channels for the diffusion of knowledge and the associated gains in output realised through

FDI. It should be noticed here that previous evidence viewing trade as a growth determinant,

claims that the role of openness to trade per se is inadequate and does not fully account for the

post-war growth in East Asia for example. The experience of Greece is equally illustrative as

it shows that trade liberalisation, while necessary is not a sufficient condition for large-scale

FDI inflows9. In our study, however, viewing the trade regime from a different perspective, it

clearly appears to be a major determinant of the pattern of stocks of FDI. Summarising, in the

case of OECD countries and after controlling for macroeconomic effects the impact of trade

is consistent with the evidence discussed in Section 2.

The role of governmental expenditures although has a positive effect on attracting FDI

it is not significant. One possible explanation is that the expenditures per se are not a major

determinant within OECD countries framework. These countries have attained a certain level

of development and the share of governmental expenditures does not significantly fluctuate.

Therefore, the incremental governmental expenditure will have a little effect on the

probability of inducing a foreign investor to undertake an investment. In our case, it seems

that public expenditure does not significantly affect the international cost competitiveness of

each country.

One of the two infrastructure indicators, rail is significant while the insignificance of

road can be explained by the fact that most of the OECD countries are highly developed and

the percentage of roads paved are not that much different among them. This is along the lines

suggested by Head et. al (1996) and Cheng & Kwan (1999, 2000) using panel data from

Chinese regions, point out the positive role played by good infrastructure (roads). The latter

study, however, reports that the coefficient estimates were insignificant, and even with the

wrong sign in the case of railways (km/km2 of landmass).

The above results, however, do not take into account the specific unmeasured features

of each country. Thus, we proceed by estimating equation (2) introducing the methods of

9 In Greece, the share of manufacturing FDI relative to GNP remained low and stagnant over the whole period

(see, e.g. U.N., 2002)

12

fixed and random effects. Firstly, we estimate a fixed-effects model that will capture all

temporally constant country-level effects. Secondly, we estimate a random-effects model.

These estimates are then compared to the previously estimated coefficients using the

Hausman test (for a comprehensive analysis of those methods see Baltagi, 1995).

The fixed effects method suggests that only the level of development and the

agglomeration effect are significant on the determination of the location of FDI, while the

random effects is consistent with the results of the common constant method analysed before.

In order to choose among the fixed effects and random effects estimator, econometric theory

suggests performing a Hausman (1978) type test of no correlation between the i and the regressors. The tests gave an 2 value of 3.78 which is distributed with 2(8) under the null and it is not significant suggesting that the GLS estimators of the random effects method are

the preferred ones.

The random-effects method reports the same results of the common constant method

analysed before, with the exception of real GDP growth, as our first method revealed

sustaining the robustness of our initial estimates. The results do not dramatically change both

in terms of the quantitative impact of the coefficients and the size of their corresponding

significance. In the light of this specification, there is evidence that the rise in GDP per capital

increases the absorbing capabilities of the recipient economy. The dominant effect of this

factor has been extensively investigated in the literature and our findings confirm that it is of

great magnitude in the case of determinants of FDI. The coefficient on the trade regime still

remains positive and significant reinforcing its robustness. Similarly, several studies have

pointed out to the importance of a liberal trade regime compared to a closed economy regime.

Sianesi (1995) using Southeast Asian data examines the role of protectionism as a proxy for

trade regime and report that it is negatively correlated with FDI inflows. Pfaffermayr (1994)

argues that there is a positive association between FDI inflows and volume of trade among

countries and finds that a foreign investor would invest in a country that has strong trade

connections. Others using manufacturing data argue that the openness to trade plays a positive

and significant role as a destination for companies. To our knowledge the openness to trade is

not explicitly taken into account as determinant of FDI and, hence, the associated empirical

evidence is limited. Based on the discussion regarding the trade regime and the patterns of

FDI our approach shed some light on the previously neglected aspects of FDI.

Both variables regarding the infrastructure are rendered positive and highly significant

suggesting that improving stocks of infrastructural capital increase the attractiveness of a

country as a platform for multinational investment. An extensive network, apart from the

13

blatant consequences in market growth, also signals the quality level of the host country. It is

likely that a large-scale improvement of the physical infrastructure would have been

facilitated by the Economic Unions regional and financial aid. Since the vast majority of our

sample countries are linked to EU, the positive effect of these variables indirectly reflects the

crucial effect of Single European Market or other similar programmes of other Integrated

Unions on the pattern of FDI. The robustness of the education variables serving as proxies

for labour quality is still evident. Neither the sign nor the significance of the as proxies or

labour quality is abolished revealing the strong effect of a skilled labour force. This effect

suggests that a highly educated and trained labour force is likely not only to attract labour-

intensive investments but also to instigate better performance of the foreign firm and larger

labour productivity. Furthermore, since much of the foreign industry is located in high-

technology manufacturing sectors the fraction of skilled labour force becomes crucial for the

patterns of FDI inflows. The governmental expenditures retain their positive sign yet seem

not to exert a significantly positive influence on the FDI inflows. Budget constraints and the

fact the global economy fluctuated during the period involved in our sample coupled with the

mature stage at which our sample countries have arrived may account for the insignificance of

this specific variable. Barrell and Pain (1997) argue that tighter domestic financial conditions

are linked to lower level of foreign investment. Wang and Swain (1995) argue that domestic

expenditures exert positive influence but their total impact does not appear robust such as the

foreign demand variables such as level of development and size. Finally, the impact of

agglomerations and its subsequent implications on the attractiveness of a country coupled

with the recent shifts to maturing products (information technology, emerging technologies)

and a potential for bringing in more R&D activity in the area of new products, remains

relatively large and significant. By boosting agglomerations, the previously undertaken FDI is

likely to instigate new techniques, process and products stimulating larger inbound foreign

investment.

6. Conclusions

Despite data limitations, the findings regarding the patterns of inbound FDI in OECD

countries offer a potential empirical framework. The significant explanatory factors consist

of: a more highly educated and trained workforce, large-scale investment in the physical

infrastructure, partly facilitated by the authorities of the corresponding Economic Union in

most cases; the level of development and market size as well as the openness to trade and the

spillover effects. All these factors are expected to enhance the attractiveness of host countries,

14

representing an additional growth dynamic. Our findings are broadly consistent with the

results obtained in the literature on the location of FDI in the US, China and Europe.

Adopting a different econometric approach, as far, as the determinants of FDI are concerned

and utilising panel data techniques, our main result is that variables such as human capital and

trade regime, as well as, the density of infrastructure appear to be robust under the different

specifications. In addition, our study confirms the significant role played by the newly

emerged factor concerning the agglomerations and contributes to the limited empirical

evidence on this area. Given this framework an extension towards including variables dealing

with labour costs and political factors will shed more insights into the dynamics of FDI. New

technologies and trends may arrive through the dissemination of knowledge transmitted by

international trade and foreign investment.

15

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18

Table 1: Determinants of FDI Summarised

Determinant Possible Proxy Variable Effect

Market Size, Market Growth, GDP, GDP Growth Rate + + +

Level of development GDP per Capita, GDP per Capita Growth Rate + +

Urbanisation %age of Urban Population +

Human Capital Secondary School Enrolment Ratio +/-

Agglomerations

FDI Lagged One Period

Number of Firms in the Region

GDP

+

+

+

Economic Integration Member of Economic-Political Union +

Governments, Trade Regime

(Exports + Imports) / GDP

FDI as a fraction of GDP

Infrastructure (Roads)

+

+

+

Labour Costs Wages and Salaries -

Exchange Rate Variability Absolute / Relative Change in Real Exchange Rate +/ -

Political Instability Foreign Debt as a Fraction of GDP

Interaction Between The Foreign

Investor and the Domestic Firms

R&D

Marketing process

+/ -

+/-

Table 2: The Determinants of FDI Empirical Evidence from a Panel of OECD Countries

Dependent Variable: (FDI/Y)i,t

Sample: 1976 1997; T=22; N=20; Total panel observations: 440

Variable Common Constant Fixed Effects Random Effects

Constant -0.151

(-0.180)

-

-

-0.027

(-0.046)

GYi,t-1 3.126

(2.261)*

4.132

(2.810)*

1.938

(1.500)

yi,t-1 0.254

(3.387)*

0.244

(1.586)

0.164

(2.886)*

(FDI/Y)i,t-1 0.673

(17.16)*

0.528

(11.50)*

0.831

(27.75)*

Gexpi,t-1 0.004

(0.793)

0.005

(0.893)

0.002

(0.465)

hi,t-1 16.63

(3.554)*

8.896

(1.109)

12.66

(4.111)*

Openi,t-1 0.579

(3.760)*

0.972

(1.538)

0.334

(3.927)*

Roadi,t-1 0.002

(1.486)

0.004

(0.426)

0.002

(2.314)*

Raili,t-1 0.146

(3.138)*

0.126

(0.712)

0.092

(3.323)*

R-squared 0.618 0.653 0.575

Adj. R-squared 0.609 0.629 0.566

D-W Stat. 2.176 2.172 1.906

Values of t-statistics in parenthesis

* denotes statistical significance at the 95% level.

19

______________________ \(1998\), Real Exchang______________________ \(1999a\), Real Exchan______________________ \(1999b\), Domestic In

______________________ \(1991\), Geography an